What Is the Greatest Lie Ever Told?

Ask a VC and he’ll tell you that it’s the myth of venture capital being an easy business.

Fred Wilson recently wrote an insightful post on this phenomenon, by showing exactly how much VCs have returned to LPs over differrent time periods. The gyst of it: over a one year period, multi-stage focus VC firms reap a return of 5.6% while NASDAQ Composite and S&P 500 enjoyed returns of 29% and 30.2% respectively. The aforementioned data is obviously not a testimonial to Venture Capital as an industry.

Cambridge Associates shows that returns from venture capital and public markets is pretty much the same over a three year period. Although this shouldn’t come as news to veterans of the industry, it does change popular perception of the VC business to the outside world. I wanted to spend some time in this post to dig in a bit further on this issue.

High Risk Does not Necessarily Mean High Reward

The aggressive, high-risk, high-reward attitude to investing adopted by fund managers in the decade preceding the 2008 crash saw a burst of institutional money flowing into VC firms, as Bill Gurley points out.According to Mark Suster, an excess of funds (LPs committed more than $100Bn to VC firms in 2000, $30Bn+ between 2005-07, and less than $20Bn in 2011) leads to reduced competition among startups for venture money, as well as an influx of inexperienced fund managers. The long and short of it: an attitude of “build first and worry about profits later” has emerged, which is both disturbing and could cause a significant fallout within the industry. Everyone thinks they can be a VC, so a ton of money is flowing into high-risk startups that would otherwise not receive any money at all.

Startups are Being Valued Incorrectly

With startups shifting focus from generating revenues to building audiences, it became all the more difficult to quantitatively analyze and value startups – just how much is a million users worth anyway, especially with competition just a click away? The reality is this: as Wilson points out, only a few startups actually exit for north of $100M, but in a recent post by Jacob Mullins, you see that very few ever reach the billion dollar threshold. So why is everyone with an office on Sand Hill Road, or a small fund trying to hit the grand slam when they are very few to be had? Seed funds theoretically chase smaller returns because they do not have to hit the home run to “win” for their fund, but smaller bets come with their own pitfalls (getting crowded out of pro rata shares for subsequent rounds, etc).

At the end of the day, VCs, small or large, still need Big Hits

The success of VC firms depends on blockbuster exits and IPOs – the ‘’Math Problem‘ discussed by Fred Wilson in another blog post nearly four years back. But the IPO market itself has dried up. Between 1980-2000, nearly 311 companies went public in the US each year. This number has petered out to just 102 per year in the past decade. While the reasons for this can be many (Sarbanes-Oxley Act of 2002, poor performance of recent tech IPOs, etc.), it represents a fundamental shift in the way startups seek exits. The likelihood of a startup getting swallowed by a larger competitor is much higher today than it was a decade ago. Google, for instance, acquired 79 companies in 2011, spending $1.4 billion in the process. Many of these were ‘acqui-hires’ – a recent trend pioneered by Facebook. While a multi-million dollar acqui-hire might be wonderful news to a startup founder, it represents poor returns for VCs (which is why some VCs are requesting protection from acqui-hires).

Bottom Line: Something Has Got to Give

With blockbuster exits drying up, increased competition among startups, and a general slowdown in VC funding, it shouldn’t come as a surprise that VC returns are at an all-time low. The VC model needs to shift based on the data that we are seeing, and focus on making fewer bets on high quality companies (rather than “spraying and praying”).